Is it time to bail on defense stocks, or is there more upside to come?
The sector, which includes giant companies such as Lockheed Martin Corp. (NYSE: LMT), Raytheon Co. (ticker: RTN), and United Technologies Corp. ( UTX), is on an impressive run, beating the broader market index by a factor of nearly 2-to-1 over the past 24 months.
Despite that frothy performance, analysts say there could be more gains to come.
The SPDR S&P Aerospace & Defense exchange-traded fund ( XAR), which tracks the stocks in the Standard & Poor’s Aerospace & Defense Select Industry index, is up about 36 percent in the two years versus 19 percent gains for the S&P 500 index, which tracks the big stocks in the market. Neither figure includes dividends.
Even before the new administration took office, it was clear that defense stocks would do well.
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Recent history. Just because the world is threatening doesn’t necessarily mean that the U.S. military will get to spend on new equipment. Under the Obama administration, the annual U.S. defense budget fell to an inflation-adjusted low of $582 billion, down from a peak $772 billion during the military build-up after 9/11, according to recent research by Morningstar.
Manufacturers of military hardware such as jet fighters, rockets and missiles have needed to cut back over the past few years, says Jim Corridore, a defense and aerospace stock analyst at CFRA in New York. The companies that make those high-tech items are now lean, which means that any additional defense orders will instantly add to profits in a big way, he says.
Good news. Despite failures in other areas of governing, such as the repeated attempts to kill off Obamacare, efforts by President Donald Trump to spend more on the military seem to be faring better. “Defense is one of the few areas where the administration is making some progress in building budgets,” Corridore says.
The Trump administration is asking for a defense budget of $639 billion for the 2018 fiscal year, which would be a big jump in inflation-adjusted terms from what Morningstar calls the “Obama trough” in spending.
It isn’t just U.S. spending of military hardware that is likely to pick up.
“Foreign-friendlies [a.k.a. allies] are also ramping defense spending to get closer to conforming with their NATO pledge, or, in the case of non-NATO countries, as a deterrent against growing global and regional threats,” says Terry Gardner, a senior managing director at CJ Lawrence in New York.
As president, Trump has lambasted some members of the NATO alliance for not spending what they promised on their own defense.
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All of this talk of more spending has sent stock prices up to levels that Morningstar says are above fair value, which is a proprietary calculation it makes to determine what the stock is worth based on a variety of factors in including the stability of future earnings.
Momentum for defense contractors. The fact that Morningstar, and others, see valuations of the stocks as high doesn’t matter to some investors. There are those who look at momentum, also known as trend following.
“I don’t give damn about price-earnings ratios because they don’t matter,” says Richard Suttmeier, CEO and founder of Global Market Consultants in Land O’Lakes, Florida. “Buyers are coming into the sector regardless of the P/E in anticipation of defense spending increases. As long as the new highs beget new highs” in the stock prices then it will be a positive bet, he says.
How to invest. It’s worth noting that the aerospace and defense businesses are inextricably linked, So while Boeing Co. ( BA) is known for commercial aircraft, it also has a military arm. Investors could choose to buy shares in other major contractors such as General Dynamics Corp. ( GD), Northrop Grumman ( NOC) and L3 Technologies ( LLL).
Alternatively, they could invest in specialty funds which buy many such stocks.
The XAR ETF has annual expenses of 0.35 percent, or $35 per $10,000 invested. Alternatively, there is the iShares US Aerospace & Defense ETF ( ITA), which tracks the stocks in the Dow Jones U.S. Select Aerospace & Defense index. It has annual expenses of 0.44 percent. Both funds are narrowly focused on the sector and they are both passive funds.
[See: 6 ETFs That Let You Buy Micro-Cap Stocks.]
For those wanting a mutual fund, try the Fidelity Select Defense & Aerospace Portfolio ( FSDAX), which an actively managed fund, meaning that the portfolio holdings change over time according to where the manager see the best opportunities. It has a minimum investment of $2,500 and annual expenses of 0.79 percent.
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Defense Stocks Are Booming and Won’t Slow Down originally appeared on usnews.com
